In a report last week, Fitch Ratings detailed an alternative to increased credit enhancement levels related to predatory-lending legislation risk. If an analysis of mortgage originators and underwriters shows strengths in their compliance procedures, such as the application of quality control tools, the credit enhancement on affected deals might be reduced, the rating agency said. However, some of the increased credit enhancement is still required because no originator can be viewed as completely isolated from this risk.
On the issue of compliance, Fitch has held discussions with the major residential MBS originators and conduits as well as securities underwriters. Based on these conversations, the rating agency said that it has enhanced its annual review of originators to include a more detailed analysis of predatory lending. The enhanced review contains documentation requests from Fitch focusing on compliance issues such as the use of technology to filter loans.
Fitch investigated originator due diligence practices through these discussions. The report said that originators generally utilize a technology-based filter in the compliance process, which is either internally produced or bought from a vendor. Fitch cannot provide credit for the compliance process without this type of filter. The rating agency thinks that it's almost impossible for these originators to monitor compliance with predatory-lending legislation without the help of technology. Fitch added that using vendor-based technology, though it might be harder to integrate into originator front-end systems, might result in improved credit enhancement levels from the rating agency.
Originators typically use some form of legal guidance to remain current with the changes in compliance legislation. To have sufficient legal resources in this area, Fitch said it is important to have both an internal counsel (with a specific person focused on origination compliance issues) as well as external compliance-specific legal advice.
Additionally, aside from the technology-based filter and expert legal advice, originators also typically implement some form of quality control review in their compliance process. These systems are used prior to and/or after funding. They vary greatly. Some firms only review a 10% random sample after the loans have been funded while others examine 100% of the loans before funding and then, post-funding, again review either 100% of all loans or 10% of the loans but 100% of all the loans in sensitive states.
Securities underwriters also perform some level of due diligence for issuers, with most of them contracting out the job. Most of the contracted due diligence is performed by a small set of firms because the work is highly specialized. The quality of the due diligence is determined by the comprehensiveness of system-based filters as well as the scope of the contract, Fitch said.
In terms of securities underwriters' compliance review, the scope also varies greatly just like those for originators. According to Fitch, some underwriters choose to review only 5% or 10% of the loans in a deal. The extent is largely based on the underwriter's comfort with the originator and/or product type. Some of these firms actually have a greater sample for sensitive regions while others require a review of 100% of the loans in the deal.
Using an independent due diligence firm is better for these underwriters than just merely relying on in-house diligence. Fitch said that compliance reviews are also a necessary part of any transaction - 10% of the loans are usually the minimum sample size. The closer the sample size is to 100%, the more favorably the rating agency would view the due diligence.